Topic 7 - Managing Liabilities

Question 1

DEFINITION OF LIQUIDITY

Answer 1

Liquidity refers to the ability of an ADI to access funds to make payments as and when they fall due

Question 2

The two main types of payments that have to be made by an ADI are

Answer 2

withdrawals by depositors and drawdowns of loans by borrowers

Question 3

The main sources of liquidity for an ADI are

Answer 3

exchange settlement accounts, holdings of other liquid assets and access to borrowed funds

Question 4

LIQUIDITY RISK

Answer 4

Liquidity risk is the risk that the ADI will be unable to access sufficient funds to make a payment It arises from the difficulty in predicting payment requirements

Question 5

To protect itself against a shortfall, an ADI will

Answer 5

hold surplus liquid assets

Question 6

The level of an ADI’s liquidity risk is determined by

Answer 6

the size of this buffer relative to the unpredictability of its payment requirements

Question 7

A liquidity shortage can be costly:

Answer 7

The ADI may be forced to reduce its level of new lending, and hence it may miss out on profitable business 
It may be unable to honour a withdrawal request, endangering the ADI’s reputation and risking the possibility of a “bank run” 
It may have to pay additional costs to access extra liquidity, such as selling long-term assets at a loss or having to borrow at short notice and high cost

Question 8

From the mid-1980s until 1999, the two main liquidity requirements imposed on banks were:

Answer 8

Prime Asset Ratio (PAR) requirements

Non-callable deposits (NCDs)

Question 9

Prime Asset Ratio (PAR) requirements

Answer 9

these required banks to keep a certain percentage of total liabilities as “prime” or liquid assets, such as cash and government securities

Question 10

Non-callable deposits (NCDs

Answer 10

banks were required to keep 1% of their total liabilities on deposit with the reserve bank (which were paid 5% less than the market interest rate)

Question 11

An ADI’s liquidity management policy will include a range of strategies, including:

Answer 11

Setting limits an maturity mismatches 
Holding sufficient liquid assets to meet anticipated liquidity needs 
Diversifying liability sources so that the ADI is not unduly affected by changing economic circumstances Developing asset sales strategies, should this be required

Question 12

The two main components in the process of ensuring the provision of adequate liquidity involve:

Answer 12

Exchange settlement accounts (ESAs) which are designed to meet the current day’s payments Estimating future liquidity requirements and ensuring that the ADI will have access to sufficient funds as and when required

Question 13

DEFINITION OF ESAs

Answer 13

Exchange settlement accounts (ESAs) are accounts held by banks with the RBA, and are used to settle interbank payments on a daily basis

Question 14

Payments can be settled in two ways

Answer 14

deferred net settlementand real time gross settlement

Question 15

DEFERRED NET SETTLEMENT (DNS)

Answer 15

DNS is used to settle cheque payments and small-value, high-volume payments such as EFTPOS and bulk electronic payments
These transactions are aggregated each night by a clearing house
The next day the clearing house advises the RBA of the net amounts owed to or by each bank, and ESAs are credited and debited accordingly

Question 16

REAL TIME GROSS SETTLEMENT (RTGS)

Answer 16

RTGS is used to settle high-value, time-critical payments
The gross amount of each payment is debited and credited to the respective banks’ ESAs, as soon as they are entered into the system
This puts greater strain on bank liquidity because there must be sufficient funds in the ESA to cover the gross amount of each payment

Question 17

An ADI’s liquidity needs will vary over time. Some of the issues that must be taken into account when estimating future liquidity needs include:

Answer 17

1. Short-term or seasonal factors
2. Cyclical liquidity needs
3. Trend liquidity needs
4. Contingency liquidity needs

Question 18

SHORT-TERM OR SEASONAL FACTORS

Answer 18

Short-term factors might include unique meteorological, economic or political events that impact upon the level of deposits and borrowing
Seasonal factors are likely to affect monthly liquidity needs in a recurring pattern from year to year

Question 19

CYCLICAL LIQUIDITY NEEDS

Answer 19

Liquidity needs can vary cyclically, in response to economic conditions, interest rates and other factor
Recessions are typically periods of high liquidity, with growing deposits but flat demand for new loans
Boom periods typically result in greater liquidity needs, with declining deposits and high demand for loans

Question 20

TREND LIQUIDITY NEEDS

Answer 20

liquidity requirements due to fundamental changes in the community in which an ADI operates
For example, rapidly expanding communities are likely to generate increasing demand for new loans, whereas stable communities are likely to generate increasing deposits with flat demand for loans

Question 21

CONTINGENCY LIQUIDITY NEEDS

Answer 21

an ADI needs to plan for unexpected variations in liquidity
These could be caused by new demand for funds, or the closure of a source of liquidity, due to an unanticipated event Liquidity management policies (approved by APRA) must include planning for such contingencies

Question 22

Stored liquidity

Answer 22

Stored liquidityrefers to assets –generally, liquid assets which held on the balance as a source of liquidity

Question 23

Stored liquidity assets can be defined as:

Answer 23

Assets in which funds are invested that will mature before the funds are required, or 
Assets that are readily saleable, without material loss, before they mature

Question 24

The main examples of stored liquidity are:

Answer 24

Cash –Notes and coins available to meet payments 
Treasury notes and Commonwealth government securities –These can be sold into the market or can be used to access funds from the RBA with repurchase agreements 
Loans to short-term money market dealers
–e.g.: “11am cash” –an overnight loan that must be repaid by 11.00am or reinvested for another day “24-hour cash” –a short term loan requiring 24 hours’ notice for repayment
Bank accepted bills 
Certificates of deposit 
Commercial paper (promissory notes) 
Semi-government securities
Other securities (e.g. corporate bonds and equities)

Question 25

Purchased liquidity

Answer 25

refers to borrowing funds as needed to meet liquidity needs

Question 26

Purchased liquidity examples

Answer 26

Exchange settlement accounts –banks with surplus funds in their accounts are usually prepared to lend to those with a potential deficit 
Interbank market –banks will often borrow from each other or from other financial institutions 
Repurchase agreements –typically using government or semi-government securities as security for what is effectively a short-term loan
Large certificates of deposit –CDs in excess of $100,000 can be issued to corporations with surplus cash 
Euro$Adeposits –Deposits raised outside Australia denominated in Australia dollars 
Other types of liabilities, such as long-term corporate bond

Question 27

Defineliquidassets.

Answer 27

Liquidassetsareassetswhichcanbesoldquicklyatafairmarketprice:thatis,without lossofvalue

Question 28

DefineliquidityriskasitaffectsanADI

Answer 28

ADIliquidityreferstoanADI’saccesstoliquidfundswithwhichitcaneffectpaymentsas they become due. These payments include paying depositors who wish to make withdrawalsandpayingoutonloanstoborrowercustomers.
LiquidityriskistheriskthatanADIwillhaveinsufficientfundsavailableaspayments becomedue.IfanADIhasdifficultymakingthesepaymentsitmaylimitnewlending thereby foregoing profitable business or it may acquire additional liquidity but at apenaltycost.If,infact,theADIcannotmakethepromisedpaymentthiswillthreaten confidenceintheADIandmayleadtoanADIrun.

Question 29

OutlinethreewaysinwhichanADImay
respondtoaprojectedshortageof
liquidity.Explainwhyeachofthese
threeresponseswillhaveanadverse
effectonbank profitability

Answer 29

IfanADIhasaprojectedshortageofliquidityitmay:
(I)limitnewlending,butthismeansnotmaking
profitablenewloanstherebyreducing profitability.
(ii) Acquireadditionalliquiditybysellingnon‐liquidassetsatalossorbyborrowing funds
atanabovemarketinterestrate,
inbothcasesthebank’scostswouldriseand
itsprofitabilitywouldfall.
(iii)Refusewithdrawalrequestsandrefuse
toallowcustomerstodrawdownapproved loans.Thisislikelytotriggerpanicamongdepositors
andarunonthebank.This wouldfurther
escalatetheliquidityshortage
andthreatentheviabilityofthebank, inwhichcasethebankwouldnotbeableto
carryoutitsnormalbusinessagain therebythreateningprofitability.

Question 30

Briefly explain the approach taken to liquidity management by APRA in its role as prudentialsupervisorofADIs.

Answer 30

APRArequiresallbankstohaveinplaceanapproved
liquiditymanagementpolicy.Thispolicy mustcaterformanagementofday‐to‐dayliquidityanditmustincludeapolicyforresponding toacrisissuchasabankrun.

Question 31

Why might ADI management impose limits on maturities as part of its liquidity managementprocess?

Answer 31

Ifmaturitiesofassetsmatchmaturitiesofliabilitiesthen
fundsreceivedfrommaturingassets shouldmatchfundspayableonmaturingliabilities
therebyminimisingliquidityrisk.

Question 32

Outlinethemainfeaturesofexchangesettlementaccounts.

Answer 32

Exchangesettlementaccountsareheldbybanksand
specialserviceproviderswiththeReserve BankofAustralia.Theyearninterestatarateequalto
theRBAtargetcashrateminus0.25%, andtheyarenotpermittedtobeoverdrawn.
Theseaccountsareusedtosettlepayments betweenADIs.

Question 33

Distinguishbetweenstoredliquidityandpurchasedliquidity.

Answer 33

Assetliquidity(orstoredliquidity)referstoholdingsof
liquidassetswhichcanbesoldif thebankneedscash.Liabilityliquidity(orpurchased
liquidity)referstoabank’sabilityto borrowfundstoprovideitselfwiththerequiredcash.

Question 34

Distinguishbetweenseasonalandcyclicalliquidityneeds.

Answer 34

Seasonalliquidityneedsreflectregularfluctuations
whichoccuratthesametimeandin thesame
directioneachyear.Forexample,when
taxpaymentsareduetherewilltypically beanincreaseinwithdrawals.Incontrastwhen
taxrefundsarereceived,thereisan increasein
deposits.Thesefluctuationscan
generallybepredictedfrompastexperience andthebankcanmanageitsliquiditypositions
accordingly. Cyclicalliquidityneedsrelatetothe
economiccycle.Forexample,abankislikelyto experienceanincreaseinloandemandduring
theexpansionaryphaseoftheeconomic cycle.Theresultingliquidityneedsaredifficult
topredict,someguidancemaybetaken from(a)theproportionoflinesofcreditcurrently
drawndown—cyclicalneedsmaybe predictedasbeingequaltothedifferencebetween
thecurrentdrawdownrateandthe maximumrateexperiencedinthepast(say10years),
(b)correlationsbetweendeposit flows and other
indicators such as interest rates, cyclical liquidity
needs should beconsideredinlightoftheleveloffunding
diversificationandreliabilityofdifferentfunding sources,(c)statisticaltimeseriesanalysis.

Question 35

Whyareforecastsofseasonalliquidityneedsgenerallybelievedtobemorereliable thanforecastsofcyclicalliquidityneeds?

Answer 35

Forecastsofseasonalliquidityneedsaregenerally
believedtobemorereliablebecause seasonalfluctuationscanbeestimatedonthebasisofpastexperienceandarelinkedto specificregulareventssuchastheduedatefortax
paymentsandtheregularperiodsfor primary producers’
expenses and income receipts. ADIs can alsoimprovetheseprojectionsbydrawingon
informationabouttheneeds
andintentionsoftheirlarge customers. Ontheotherhand,cyclicalliquidityneedsarelargely
relatedtobroadmovementsintheeconomy.
Thesearerelatedtoawiderangeofbothdomestic
andinternationalfactors.
Hence, while it is expected that the economy will
follow a cycle of expansion and contraction,itisverydifficulttoforecastthesizeof
eachmovementandtheturning pointsofthecycle.

Question 36

InwhatsensecouldanADIhaveanoptimallevelofliquidity?

Answer 36

AnADIshouldaimforanoptimallevelofliquidity.This positionoccurswhenthemarginal benefitofreducedliquidityriskfromanextradollarofliquidityisequaltothemarginalcostofthatadditionaldollarofliquidityduetothereducedinterestrevenue.Abankwouldhavetoo muchliquidityifithadinexcessofthisoptimumandtoolittleliquidityifithaslessthanthis optimum.

Question 37

Whatarecontingentliquidityneeds?Whyisitparticularlydifficulttoprovideforthisform ofliquidity?

Answer 37

Contingentliquidityneedsareduetounusualeventsthataredifficulttopredict.Forexample,if anotherbankbecomesinsolventthismaytriggerarunonyourbank. Itisdifficulttoplanforthistypeofliquidityfirstly,becauseofthedifficultyofpredictingthe timingoftheseeventsandsecondly,becausetheliquidityrequirementislikelytobeextremely largeeventhoughitmayonlybeforarelativelyshortperiod.